Bigger dividends in 2013?

Experts say the tax deal isn’t the only reason to be optimistic

IanSalisbury

An earlier version of this story misspelled fund manager Brian Shepardson’s name.

Dividend investors came out of the fiscal-cliff deal relatively unscathed — a development experts say may spur companies to make bigger payments in 2013.

Investors applauded the compromise in Congress, which kept the dividend tax rate at 15% for most investors. Tax rates for those earning more than $400,000 will jump to 20%. (Added to these rates is a new Medicare 3.8% surcharge for those making $250,000 or more, bringing the toprate to 23.8%.)

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That relatively mild increase could encourage more cash-rich companies to boost dividend payouts. Experts say fear of the fiscal cliff had been weighing on corporate executives. Without the deal, dividends could have been taxed at the same rates as regular wages — up to 43.4%. As a result, some companies appeared to rush out payments to avoid a possible tax hike. Costco, for instance, went so far as to borrow $3.5 billion to make a hefty $7-a-share. Many feared that other companies that didn’t beat the deadline might simply have held off on dividends, finding other uses for their cash instead. “This outcome is the one we’d been hoping for,” says Judy Saryan, co manager of the $1.1 billion Eaton Vance Dividend Builder mutual fund.

In addition to the tax rates being kept low, dividend investors have further reasons to be optimistic, according to Standard & Poor’s analyst Howard Silverblatt. Companies in the S&P 500 paid out a record $281.5 billion in dividends in 2012, up 17% from 2011. Silverblatt expects a jump of 3.6% in 2013 based on bigger payments that companies have already committed to but didn’t make for the entirety of last year. The financial health of these companies is also encouraging. Payout ratios — the percentage of profits corporations hand back to shareholders as dividends — are only about 36%, well below their historical average of about 52%. “They’ve got significant cashflow,” he says.

Apart from simply avoiding the maximum rate spike, dividend fans also cheered the fact that Congress kept rates level with those that apply to capital gains, a parity established with the 2003 Bush tax cuts. Critics blamed the discrepancy between capital gains and dividend taxes for encouraging corporate executives to focus too closely on their stock’s price and not enough on handing money back to investors, leading to everything from the spread of stock buybacks in place of traditional payouts to the aggressive accounting that ultimately led to many of the era’s most prominent scandals. “It’s important to signal to corporations that dividends should be a strong contender for their cash,” says Saryan. “It gets you back to a traditional type of investing.”

Dodging this bullet couldn’t have come at a better time for income-strapped income investors. On average, stocks in the Dow Jones Industrial average yield about 2.5% — not much considering annual inflation is about 1.8%. But the Federal Reserve’s effort to hold down interest rates means investors have had trouble finding suitable yields elsewhere. One popular alternative, corporate bonds, yield about 2.6%, less than one percentage point above 10-year Treasuries. While bonds tend to be less volatile than stocks, bond investors face losses if interest rates rise, as many think they will sooner or later.

The attraction of dividends versus corporate bonds is one reason the $1.8 billion James Balanced Golden Rainbow fund started snapping up these stocks late last year, according to co-manager, Brian Shepardson. The managers had figured other investors might be overreacting to the risk of a big tax hike. They’re also not phased by the smaller one that came to pass when Congress finally struck a deal.“We’ll continuing to buy,” he says.

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